Again and again over the past few years I’ve said that it was premature to worry about the deficit. In 2018 I argued there was no need to insist that President Donald Trump’s tax cuts be paid for. In 2021 I wrote that Congress needn’t skimp on a third round of pandemic relief.
I would now like to make an announcement: I am beginning to be worried about the deficit. High U.S. budget deficits are not a problem yet, but it’s quite possible they will be in the near future. Congress should be looking for ways to end both excess spending and unproductive tax breaks for higher-income Americans.
To get a handle on what has changed, and how concerned to be, it’s necessary to look at the two main arguments over the last decade for austerity — and why they were wrong.
The first was that the U.S. was running deficits in excess of the cost of servicing existing debt. It was only a matter of time, according to this argument, before there would be exponentially rising interest costs that would burden future generations. In particular, the Congressional Budget Office forecast in early 2018 that, partially as a consequence of the Trump tax cuts, interest costs on the debt would nearly double from 1.4% in 2017 to 2.7% in 2022. Longer term projections had them skyrocketing from there, to 6.8% in 2048 (which, if accurate, would have been as much as the federal government was projected to spend on Social Security that year).
In fact — after the Trump tax cuts, a repeal of the appropriations sequester and three multitrillion-dollar pandemic relief bills — interest costs on the debt are on track to be just 1.2% of GDP this year.
This isn’t simply a fluke caused by the oddities of the pandemic. The CBO has consistently overestimated interest costs of the debt. It has failed to appreciate that in the last few decades the U.S. economy has been mired in what economists call secular stagnation, which is in part characterized by interest rates that are persistently below the growth rate of the economy.
Which brings us to the second argument: Some deficit hawks acknowledged that the U.S. was in a period of extraordinarily low interest rates. But they warned that this phenomenon could reverse itself at any time. What they misunderstood is the effect that the response to secular stagnation would have on the overall economy in the short term.
The transition to lower interest rates would require a rapidly accelerating nominal GDP — which in turn would require real growth, inflation or some combination of the two increasing at a much faster rate than at any time in the preceding 20 years. When that happened, both the tax base and the size of the overall economy relative to the debt would expand.
In the near term, that would actually make it easier for the federal government to service the debt. It would also give policymakers some notice that they needed to adjust their expectations.
This is precisely what is happening in the U.S. economy right now. After collapsing to negative 8% year-over-year in spring 2020, and then rebounding to a positive 16% year-over-year in spring 2021, nominal GDP growth was at 11% year-over-year as 2021 came to a close. Before the pandemic, the last time nominal GDP growth was above 11% was in 1984.
Yes, that was in large part due to rapid inflation. But from a budgetary perspective, a burst of inflation also helps to ease the debt burden. That’s why debt as percentage of GDP has actually fallen over the last year. And the boost in nominal GDP should further reduce the overall debt burden in 2022 — but the effect won’t last much longer than that.
The Federal Reserve has already started to raise interest rates. Doing so will slow inflation (and nominal GDP growth) — and raise the cost of servicing the debt. The rise in interest rates is likely to be gradual, because the Fed does not want to risk a recession.
Congress has some time to act — but only some. Although the worst fears of budgets hawks didn’t come true, the carefree era of deficit spending is over. Washington needs to adjust to the new reality.
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